Balance sheet is nothing but another financial document that we accomplished prepared to provide a user with more information about the financial potition of a company. you can look up your textbooks for a more formal definition.
An analogy that I like to use I read another book long time ago was that of a financial photograph. A balance sheet is like a financial photograph. What I mean by that? If you are all sitting in my classroom and I took a picture of you right now, the camera would record your posture at the moment the flash went off.
But one milllion seconds after I took the picture all of your posture could conceivably change. So similarly the balance sheet records the financial position of a company as of a certain date. It could be as of December 31st 2012 or as of April 30th 2013 etc.
Now the balance sheet is broadly classified into three main sections assets, liabilities and stockholders equity also called shareholders equity.
What is an asset, I like to use a one word working definition of an asset as something that the company owns. Just as you own a number of things in your personal lives. What are some things that you own, clothes, a car, may be more than one car, a house etc. All of these are your assets.
Similarly a company owns or can own a number of different items as well. Now for balance sheet reporting purposes the assets are further sub classified into several sub sections.
The first sub section under the asset group would be current asset, so what is a current asset. By definition a current asset is cash or any other asset that can be converted into cash within one year.
GAAP specifies which accounts for current assets. Here are this illustrated two of them cash and account receivable as examples.
Account receivable also called AR, what is an accounts receivable? When does an AR come on a company’s book? AR typically comes about when a company sells a product or provides a service on credit on account. On account is another term for on credit, so again if you were a company selling clothes and you sold clothes to a customer on credit, then that creates an accounts receivable on your books.
So in keeping with a one word definition of an asset and that is something that the company owns, what is it that you the business owner owns, so the company owns when you have an AR.
In this case what will happen is the company owns the right to receive money from the customer at a future specified date. So initially when the company sells those clothes on credit that creates an AR the company’s AR goes up.
When the customer sends the money, makes the payment and the company receives the check that reduces the company’s AR. So that’s a little bit about how AR comes about on a company’s books and how it goes down.
Next we have other sections that broadly fall into the umbrella of long term assets. The first of these subsections that fall under the broad umbrella of long term assets would be property, plant and equipment. And some examples of accounts that fall in the property, plant and equipment subsection would be land and building.
Then you have another subsection called intangible assets. Some accounts that fall under this subsection would be goodwill and patents. Then we have another subsection which is kind of a catch-all section called other assets, and one account that typically falls into the other account other assts section will be deposits.
What I mean by a deposit? Let’s assume you are starting a company for the first time and you need to set up an account for the utilities, so you call up the utility company, and because you have no prior history with that company, they say to you send us a check for $1,000 as a deposit.
And once your company establish a payment track record with them a good payment track rocord let’s say for six months, they will return that $1,000 to you. So $1,000 that you send into the company is not a payment for your bill. It’s just a deposit that the company is going to hold till they’re satisfied that you have a good credit record a good payment record with them and then they return the money to you.
So your company owned that money all along hence it’s an asset for you even though the utility company is physically holding to that cash, and so on your books on the balance sheet you would classify that as a depoist.
So when you add up all of these subsections that will give a total assets dollar figures. So that’s a little bit about assets and the different components that make up assets.
Then we’ll move on to the next section called liabilities. One word definition of a liabilities would be something that the company owes. Do you owe anything anybody in your personal lives? Most of us do. It would be student loans, it would be a loan for your car, in mortgage on your house, money that you owe for your taxes, so these are all liabilities to you.
Similarly a company has various types of liabilities. One would be accounts payable. Accounts payable is an account it’s a liability account obviously, and it is used when the company purchases items on account for everyday use. So let’s assume that they go to a office supply store like Office Depot or Staples and they buy supplies on credit that create an accounts payable on the company’s books
Oftentimes students tend to get confused between accounts receivable AR and accounts payable AP. Well don’t. Look at the words carefully accounts receivable that means the company is going to receive something and one way the company would receive something would be if they were to have sold a product or provided a service.
Conversely accounts payable focus on the word payable. Why do you have to pay. You have to pay because you purchased something and in this case would have purchased something on credit. So accounts payable would be one account wages payable.
You’re an employer, every day your employees come to work for you, but do you pay them every day? Probably not. So at the end of each day let’s assume you pay them once a week on a Friday. So when your employees finish working for you on a Monday. Don’t you the employer owe them some money as of the end of that day for the work that they’ve done? Yes, you do and the next day when they come in and do another day’s worth of work, you will now have owe them for two days Monday and Tuesday.
So this these items will be reflected in terms of wages payable. And when do the payables get off your books, the payables go off your books? Once you make a payment. So whether it be a payment to Office Depot or staples or whether it be a payment to your employees, once you make a payment that brings your payable down. Then both of these payables both of these accounts come under the current libraries section.
Now what is a current liability? A current liability would be basically a liability that you will pay off within one year now. The next subsection under liabilities would be long-term liabilities then again you could have different accounts, I just illustrated one account long-term notes payable. You buy a car for instance, you sign a promissory note with a bank and oftentimes those car payments are made over many years so all those payments that you have to make all the principal balance that you owe on your car pass one year after making one your payments. That principle would be reflected in your long-term notes payable.
The amount of original loan that you have to pay off within one year that would be classified in the current liabilities section.
Then we’ll talk a little bit about the stockholders equity. One way to understand the stockholders equity would be the owners claim on the assets of a company. And typically again there are different accounts that make up your stockholder equity. One would be common stock. When does common stock come a on company’s book, when you first form a corporation. In consultation with your attorney you will file that necessary paperwork and as a result of that you will issue what I called shares.
Shares are another word for stock. When company owns only one type of stock, it’s common stock. If a company chooses later to sell a second type of stock that would be called preferred stock, so common stock represents ownership interest in a company.
If you and your freind hypothetically were to start a company, and you all decided to issue 1,000 shares and you own 400 of those 1,000 shares then your ownership would be 40 percent of the company.
But all of the 1,000 shares would be reflected in the common stock account. Now when you first issue common stock in consultation with the attorney you also and also based on state regulations you have to establish a value for that shares that value is a semi arbitrary value, but it has a lot of legal implications could be called a stated value or a par value dependiing on your state regulations.
Retain earnings is an example of another account within the stockholder equity family The retained earning account typically holds the company profit. Every month as a company generates profits those profits go into the retained earning account. So retained earning accounts keeps increased every time the company generates profit.
Conversely every time the company has losses, the retained earning account decreases. Another type of transaction that causes your retained earning to go down would be that payment of dividends.
Dividends are a destribution of the company’s profit to the shareholders and so every time a company declares dividends then those dividends come out of the retained earning account because that’s where the company’s profits are held. Another way to understand stockholders equity is to think of that as a net worth of a company. We don’t use the term net worth winning weights of companies but we trend to use the words net worth as it relates to us individuals.
So you all have heard of the term a millionaier. Think about it, what makes an individual a millionaier? If I want to have a million dollar houses, does that make me a millionaire? And the answer is no, not necessarily, so what makes me a millionaier then if you look at the accounting equation here, total assets equals total liabilities and stockholders equity, that’s assets equals liabilities plus equity.
If you rearrange the equation your stockholders equity would be the difference between your total assets and your total liabilities. So in order for me to be a millionaier, I would have to have the difference between my assets and my liabilities to be at least a million dollars.
So going back to my earlier example if I were to buy a million dollar house, let’s assume I don’t own any other assets, just for simplicity sake just that one asset. But I owed if I borrowed nine hundreds thousand dollars to buy that house, that means my stockholders equity then would only be the differential one hundred thousand that hardly makes me a millionaiere may give me bragging rights that I have a million in our house but it does not make me a millionaier. However another hand if I bought a million dollar house with cash outright cash and I don’t have any other liabilities, then I could say I’m a millionaier because the difference between my assets million dollars and my liabiliitie is zero is equal to net worth or equity of 1 million dollars.